“Firm Wages in a Frictional Labor Market”: A Critique

Leena Rudanko’s paper (“Firm Wages in a Frictional Labor Market,” AEJ:M, 1/2023) is ambitious, attempting to integrate known characteristics of wage setting into mainstream friction-augmented general-market-equilibrium (FGME) modeling – a task about which New Keynesians (NK) are typically shy. Her analysis is praiseworthy for her insistence on looking inside establishments for answers to consequential questions:

• She recognizes that a great deal of wage determination occurs inside large firms – a  critical first (usually ignored) step in the adequate modeling of labor pricing.
• She attempts to account for “within-firm equity constraints on wages” – a primary concern of wage administrators that is ignored by NK theorists. Inattention to perceived equity scuttles rational analysis of evidence-consistent labor pricing.
• She explores why “firms find it profitable to fix wages” – another important real-world issue in wage determination .
• She understands that the intra-firm link between labor pricing and productivity is much more complex than the market-equilibrium mandate to equilibrate wages and marginal productivity.

Despite consideration of important questions, Rudanko’s analysis does not succeed. The reason is fundamental. Market-centric modeling, even endowed with a full range of frictions, cannot rationally suppress wage recontracting sufficiently to support useful stabilization modeling. That is especially true with respect to Keynes’ central problem of mass involuntary job loss (IJL) – a point famously made by the late Robert Lucas.

• IJL causes almost all of the increase in unemployment in periodic recessions. The hard fact is that frictional (voluntary) unemployment is unimportant in the analysis of macro instability, while stabilization-relevant macro theory is not feasible absent involuntary job loss.
• Significant search/match frictions are inherently associated with frictional (voluntary) unemployment.
• In particular, neither decreasing the frequency, nor increasing the staggering, of wage adjustments can rationally suppress wage recontracting. Indeed, no rational market friction has been identified as  a significant causal agent in mass involuntary job loss. As Barro used to remind us, the inherent immediacy and power of the choice between continued employment and maintenance of existing wage rent rationally sustains continuous recontracting. Rudanko’s frictional labor market, despite the huge NK investment in the mechanics of hiring labor, cannot accommodate mass involuntary unemployment.
• As noted, Lucas advised macro theorists to ignore involuntary job loss. It pays to pay attention to Lucas. He was, of course, too careful to deny the obvious existence of IJL. His relevant quote (1981, p.243) is: “Involuntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain.” He was arguing, insightfully, that meaningful  IJL cannot exist in general market equilibrium. If theorists choose to work within that framework, which he believed Keynes did not, IJL must be ignored.

Generalized-exchange theory, featured in the GEM Project, is a much more persuasive treatment of wage setting inside large, highly specialized firms:

• The Project’s two-venue model intuitively generalizes rational exchange from the labor market (with its full slate of NK frictions) to workplaces restricted by inherent employer-employee information asymmetries. Since the Second Industrial Revolution, such workplaces have accounted for a majority of the total labor force.
• Information-challenge workplace equilibrium produces two classes of rational wage rigidities (WR): downward nominal inflexibility over stationary contractions in aggregate demand and chronic wage rent.
• Those rational-behavior wage rigidities combine with adverse disturbances in nominal demand to produce two varieties of involuntary job loss: temporary layoffs that occur in the millions in recessions (consistent with stationary spending disturbances) and permanent downsizing that occur in the millions in depression (consistent with nonstationary spending collapse).
• Generalized-exchange labor pricing is crucially motivated by optimizing employer-employee interaction organized by general decision-rule equilibrium. It is consistent with the 1990s New Neoclassical Synthesis, which provides fundamental standards for macro modeling that were accepted by New Keynesian (NK), New Classical, and Real Business Cycle theorists, ending the macro wars.
• The NNS compromise paid particular attention to rational behavior. Indeed, if faced with a choice between rationality and the evidence, the jump ball goes to the former. While I admit to being uncomfortable with that always being the correct selection, a long career making sense out of difficult, high-stakes macro problems has persuaded me that close, not perfunctory, attention should be paid to rational behavior. Substituting assumptions of convenience almost always misleads, typically badly. At a minimum, resorting to such convenience must be carefully justified.

Reiterating for emphasis, the casual scrapping of rationality, particularly in labor pricing, has robbed NK modeling of powerful guidance. Carefully pursued, rational behavior has a record of opening up analyses to important, at times unanticipated, results. In that context, a long progression of NK research illustrates a consequential puzzle in the 21^st century development of macro theory.

The GEM Project sets up the puzzle. It has successfully modeled and made available rigorous rational-behavior wage determination consistent with the full range of available evidence. Its two-venue approach generalizes rational exchange from the marketplace to information-challenged workplaces. Powerful workplace-marketplace-synthesis results can be incorporated into NK research, making mainstream analyses much more consistent with both the Neoclassical Synthesis and the accumulating evidence at almost no cost. In so doing, and perhaps this is the rub, NK theorists would be acknowledging that a key to the useful treatment of labor pricing after the Second Industrial Revolution is the cojoining of the intuitive second (workplace) venue of rational exchange and textbook market-centric modeling. The new venue is comprised of firms in which workplace employer-employee information is inherently asymmetric. That condition characterizes a substantial share of the total labor force in modern, highly specialized economies, making models that confine labor pricing wholly to the marketplace deeply problematic. The exclusion of millions of workers in large, highly specialized firms from mainstream (market-centric) analysis is a problem that macro theorists ignore to their own peril.

That leads to the critical puzzle. Paying attention to the fact of information-challenged workplaces would immediately upgrade a great deal of NK research to the elite status of macro models, i.e., rooted in neoclassical tenets of optimization and equilibrium while being consistent with a broad range of stabilization-relevant evidence. What’s not to like? Perhaps reservations are at least partially rooted in the significant human capital that needs to be acquired in order to effectively model rational behavior in information-challenged workplaces. It may seem like too much work. In addition, perhaps the fundamental changes introduced by the two-venue model, despite being evidence-consistent, are off-putting. However, if NK theorists really want to be stabilization-relevant, it is time to accept the initial inconvenience of the intuitive generalization of rational price-mediated exchange.  

Blog Type: New Keynesians